Auditors and third party liability – judicial reassurance

Man Nuzfahrzeuge AG and Others v Freightliner Ltd and Others [2005] EWHC 2347

The issue of auditors’ liability to third parties has been brought sharply into focus recently with The Company Law Reform Bill which embodies some significant changes in relation to auditors’ liability, namely the ability to negotiate “Liability Limitation Agreements” (for more on this, see our Law-Now of 16 January 2006). However, with regard to third party claims, the Government has decided not to codify any statement of auditors’ duty of care, as expressed by the House of Lords in Caparo Industries v Dickman [1990] 2 AC 605, [1990] 1 All ER 568, HL. Auditors therefore remain reliant on the judiciary to determine the circumstances in which damages for economic loss can be recovered by third parties who allege they have relied on the audited accounts to their detriment.

The recent case of MAN v Freightliner is a useful reminder of the judicial principles governing this area of law which, following the controversy generated by the decision in Royal Bank of Scotland v Bannerman [2005] CSIH, provides some comfort to auditors (for more on the Bannerman case please see our Law-Now of 8 January 2003). The Bannerman case aroused considerable interest principally because of the court’s finding that the absence of a disclaimer could point to the assumption of responsibility by the defendant auditors to the claimant bank (notwithstanding the absence of any direct contact between them) as the auditors knew the bank would rely upon the audited accounts when making its lending decision.

The Facts

The proceedings arose out of the acquisition of the truck manufacturer, ERF, in June 1996, by a Canadian manufacturer, Western Star, which was subsequently acquired (July 2000) by Freightliner, (an American subsidiary of Daimler-Chrysler AG). MAN (a subsidiary of a large German industrial group) acquired ERF in early 2000 by way of a share purchase agreement from Freightliner. It subsequently transpired that from about the middle of 1997, the accounts of ERF (both the monthly management accounts and the year-end statutory accounts) had been persistently manipulated by its financial controller, Mr Ellis, who from about the same time had also been responsible for systematic frauds on HM Customs and Excise by means of false claims for the repayment of VAT.

MAN issued proceedings against Freightliner seeking to recover damages for the false accounting under warranties in the share purchase agreement. It was accepted that, as a result of Mr Ellis’s manipulations, the relevant books of account had not given a true and fair view of ERF’s financial position, and that there had accordingly been breaches of the share purchase agreement by Freightliner. The latter brought a Part 20 Claim against ERF’s UK based accountants, Ernst & Young, and against Western Star’s Canadian accountants, Ernst & Young Canada, contending that if, as the Trial Judge held, it was liable to MAN in respect of Mr Ellis’ fraud, it was entitled to recover from E&Y (UK) on the grounds that its liability had resulted from the breach of one or more duties owed by E&Y (UK) to Western Star in relation to the audit of ERF and the due diligence exercise.

The Issues

It is a well established principle that although the auditors’ primary duty is owed to the company pursuant to the contract under which they are engaged, they also owe a duty of care under the general law to the shareholders, as a body, who can be expected to exercise their rights and powers in a general meeting on the basis of the audited accounts: Caparo Industries Plc v Dickman. In the MAN case this was referred to as the “general audit duty” which it was accepted E&Y (UK) owed to Western Star.

The Trial Judge rejected Freightliner’s argument that Western Star was able to rely on a breach by E&Y (UK) of this general audit duty and to recover in its own name losses in the form of any liability it may have incurred to MAN as a result of the dishonesty of Mr Ellis. Moreover, the loss in this case was not one which arose out of the mismanagement of ERF but the dishonest acts of Mr Ellis, including statements of Mr Ellis during the course of the negotiations in respect of the sale of the company. Furthermore, Freightliner’s argument that the general audit duty included specific duties - such as a duty to inform Western Star that the audit partner had become concerned about Mr Ellis’ competence and integrity, and a duty to investigate a tip-off and to modify the audit work in light of it - simply served to reinforce the Caparo principle that any such duty was owed to the shareholders as a body and not to individuals.

In light of the fact that Freightliner could not rely on a breach of the general audit duty to recover its loss, the Trial Judge went on to consider whether E&Y (UK) owed Western Star a “special audit duty”: a duty at common law to take reasonable care when carrying out their audit to protect it from the kind of harm it suffered in this case.

In deciding the circumstances in which the auditors of a company owe a duty of care to a third party with whom they have no contractual relationship the Courts have been divided in their approach: the “threefold” test of forseeability, proximity and fairness as rooted in Caparo and the assumption of responsibility test originating in Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964] AC 465 and adopted in Henderson v Merrett [1995] 2 AC 145. Although the principles relating to both approaches are well established (and should at least in theory result in the same outcome as per Sir Brian Neill in Bank of Credit and Commerce International (Overseas) Ltd v Price Waterhouse [1998] BCC 617), their application in any particular case may not be straightforward because the Courts have been wary of imposing a duty on professional advisors to anyone other than their clients.

An auditor will only be held to owe a duty to a third party if it can be shown that they knew, and intended, that their statement as to the audit client’s accounts would be communicated to, and relied upon, by a particular person or class of persons for a particular purpose in connection with a particular transaction. Whether an auditor has assumed responsibility to someone other than his client is a matter to be determined objectively by reference to all the circumstances of the case. As the Trial Judge put it:

“it was common ground that whether an auditor has assumed responsibility to someone other than his client is a matter to be determined objectively…close attention must be paid to the particular statement on which the Claimant seeks to rely, the circumstances in which and purpose for which that statement was made and the type of loss which the Claimant is seeking to recover. The auditors will only be held to have incurred such a duty if it can be shown that they knew and intended that their statement as to the company accounts would be communicated to and relied on by a particular person or class of persons for a particular purpose in connection with a particular transaction.”

The transaction which gave rise to the loss in the present case was the sale of ERF by Western Star to MAN. It is that transaction which needed to be analysed, therefore, in considering whether E&Y (UK) assumed a responsibility to Western Star or indeed, anyone else, for the accuracy of its audit. The Trial Judge held that given the nature of the relationship between Western Star and ERF and between E&Y (UK) and E&Y (Canada), E&Y (UK) must have realised that both the 1998 and 1999 audit reports would be passed to Western Star, who could be expected to rely on them both for the purposes of producing consolidated accounts for the Western Star Group as a whole and for the purposes of making decisions about the future conduct of ERF’s business. The Trial Judge was not persuaded, however, that at the time it produced its 1998 audit report, E&Y (UK) could be taken to have known that Western Star would rely on it for any other purpose. The fact that E&Y (UK) may have recognised that Western Star might have decided to dispose of ERF at some uncertain date in the future did not give rise to a relationship between them that would normally be regarded as sufficiently close to support a duty of care; this serves to reinforce the point that mere forseeability that audited accounts may be used for another purpose is insufficient to give rise to a duty of care.

This point was amplified in relation to the 1999 accounts. In September 1999, E&Y (UK) were aware of the existence of the negotiations with MAN and it was made clear before the audit report was signed that Western Star was anxious to obtain the audited accounts as soon as possible in order that they could be made available to MAN for its consideration in connection with the purchase of ERF. It was submitted on behalf of E&Y (UK) that they did not provide a copy of the true 1999 accounts for any purpose relating to the sale of ERF and did not undertake any responsibility to Western Star for their accuracy in relation to any aspect of that transaction. The Trial Judge found that the circumstances were such that it was foreseeable that Western Star would rely on the accounts in the negotiations with MAN as presenting a true and fair view of ERF’s financial position. The Trial Judge reiterated that this was not enough to give rise to a duty of care; it was also necessary for

“there to have been a relationship between the parties of such proximity as to support the conclusion that there was an assumption of responsibility…in such cases it becomes necessary to look carefully at the precise purpose for which the statement was communicated to the Claimant. These are likely to be important considerations because unless it can be shown that the statement was communicated to the Claimant for a particular purpose relating to the harm he has suffered he is unlikely to be able to show that the Defendant assumed responsibility to take care when making it to protect him from that harm.”

There was no evidence of anything passing between Western Star and E&Y (UK) to indicate that Western Star was intending to rely on the accounts for any particular purpose in its negotiations with MAN and, in signing the audit certificate, E&Y (UK) were not assuming responsibility for the accuracy of the accounts for any purposes of that kind. E&Y (UK) knew that MAN was carrying out a due diligence exercise but, apart from making their audit papers available to Deloitte & Touche, they were not consulted about it and played no part in it.

Furthermore, the Trial Judge found that the loss suffered by Freightliner in this case took the form of a liability in damages for deceit arising from the statements made by Mr Ellis in the course of the negotiations with MAN, rather than the inaccuracy of the accounts themselves, and that this was not a loss that E&Y (UK) assumed a responsibility to protect Western Star from.

One further issue that is illustrated by the MAN case (and leaving aside the general issue as to when a disclaimer may be appropriate post Bannerman) is the care that needs to be exercised when drafting any form of disclaimer. Before releasing its working papers to Deloitte & Touche for the purpose of the due diligence exercise, E&Y (UK) insisted on receiving “hold harmless” letters from both Western Star and MAN. The letters made it clear that although E&Y (UK) were prepared to allow access to their working papers and to provide information and explanations in relation to the work they had done for the purposes of the audit, they were not willing to accept liability for the consequences of giving MAN access to the information which would not otherwise have come into its hands. The Trial Judge found that although “Information” was defined in the letters as meaning any information derived by the recipients from the working papers, that did not include the audit report produced by E&Y (UK) itself on the basis of the work reflected in the papers. The “hold harmless” letters could not therefore be understood as relating to wider questions of responsibility or to any liability that might arise out of the use to which the statutory audit might be put.

Conclusion

The MAN case therefore usefully illustrates the circumstances in which an auditor will be found to owe a third party a duty of care:

i) the loss must be foreseeable;

ii) there must be a relationship of considerable proximity;

iii) it must be fair, just and reasonable in all the circumstances to impose a duty of care;

iv) the auditor must be expressly made aware of the third party’s likely reliance on the accounts for the particular purpose; and

v) the auditor should have intended that the third party rely on the accounts for that purpose; absent intention an auditor may still, viewed objectively, be found to have assumed responsibly to a third party.

In light of the Government’s decision not to codify the law in this area, the MAN decision can be seen as judicial reassurance that well-established principles remain just that. It is worth noting that E&Y (UK) succeeded at trial on, in essence, the same grounds that were unsuccessfully advanced at a strike out application in respect of the Part 20 claim. Auditors and their insurers will hope that (whilst there will be situations which are particularly fact sensitive and the Court will wish to make a detailed investigation before passing judgment), clear cases will continue to be dealt with in favour of auditors without the need for a full blown trial.